## Presentation on theme: "10 - 1 Copyright © 2002 Harcourt, Inc.All rights reserved. CHAPTER 10 Stocks and Their Valuation Features of common stock Determining common stock values."— Presentation transcript:

10 - 1 Copyright © 2002 Harcourt, Inc.All rights reserved. CHAPTER 10 Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

10 - 3 Copyright © 2002 Harcourt, Inc.All rights reserved. Classified stock has special provisions. Could classify existing stock as founders shares, with voting rights but dividend restrictions. New shares might be called Class A shares, with voting restrictions but full dividend rights. Whats classified stock? How might classified stock be used?

10 - 4 Copyright © 2002 Harcourt, Inc.All rights reserved. When is a stock sale an initial public offering (IPO)? A firm goes public through an IPO when the stock is first offered to the public. Prior to an IPO, shares are typically owned by the firms managers, key employees, and, in many situations, venture capital providers.

10 - 6 Copyright © 2002 Harcourt, Inc.All rights reserved. Dividend growth model Using the multiples of comparable firms Free cash flow method (covered in Chapter 12) Different Approaches for Valuing Common Stock

10 - 7 Copyright © 2002 Harcourt, Inc.All rights reserved. One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock?

10 - 10 Copyright © 2002 Harcourt, Inc.All rights reserved. What happens if g > k s ? If k s < g, get negative stock price, which is nonsense. We cant use model unless (1) g k s and (2) g is expected to be constant forever. Because g must be a long- term growth rate, it cannot be k s.

10 - 11 Copyright © 2002 Harcourt, Inc.All rights reserved. Assume beta = 1.2, k RF = 7%, and k M = 12%. What is the required rate of return on the firms stock? k s = k RF + (k M - k RF )b Firm = 7% + (12% - 7%) (1.2) = 13%. Use the SML to calculate k s :

10 - 12 Copyright © 2002 Harcourt, Inc.All rights reserved. D 0 was \$2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. k s = 13%. 01 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 D 0 =2.00 13% 2.12

10 - 13 Copyright © 2002 Harcourt, Inc.All rights reserved. Whats the stocks market value? D 0 = 2.00, k s = 13%, g = 6%. Constant growth model: = = \$30.29. 0.13 - 0.06 \$2.12 0.07

10 - 14 Copyright © 2002 Harcourt, Inc.All rights reserved. What is the stocks market value one year from now, P 1 ? D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus, ^ \$32.10.

10 - 15 Copyright © 2002 Harcourt, Inc.All rights reserved. Find the expected dividend yield and capital gains yield during the first year. Dividend yield = = = 7.0%. \$2.12 \$30.29 D1D1 P0P0 CG Yield = = P 1 - P 0 ^ P0P0 \$32.10 - \$30.29 \$30.29 = 6.0%.

10 - 16 Copyright © 2002 Harcourt, Inc.All rights reserved. Find the total return during the first year. Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13%. Total return = 13% = k s. For constant growth stock: Capital gains yield = 6% = g.

10 - 17 Copyright © 2002 Harcourt, Inc.All rights reserved. Rearrange model to rate of return form: Then, k s = \$2.12/\$30.29 + 0.06 = 0.07 + 0.06 = 13%. ^

10 - 18 Copyright © 2002 Harcourt, Inc.All rights reserved. What would P 0 be if g = 0? The dividend stream would be a perpetuity. 2.00 0123 k s =13% P 0 = = = \$15.38. PMT k \$2.00 0.13 ^

10 - 19 Copyright © 2002 Harcourt, Inc.All rights reserved. If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P 0 ? k is still 13%. Can no longer use constant growth model. However, growth becomes constant after 3 years. ^

10 - 20 Copyright © 2002 Harcourt, Inc.All rights reserved. Nonconstant growth followed by constant growth: 0 2.3009 2.6470 3.0453 46.1135 1234 k s =13% 54.1067 = P 0 g = 30% g = 6% D 0 = 2.00 2.603.38 4.394 4.6576 ^

10 - 21 Copyright © 2002 Harcourt, Inc.All rights reserved. What is the expected dividend yield and capital gains yield at t = 0? At t = 4? Dividend yield = = = 4.8%. \$2.60 \$54.11 D1D1 P0P0 CG Yield = 13.0% - 4.8% = 8.2%. At t = 0: (More…)

10 - 22 Copyright © 2002 Harcourt, Inc.All rights reserved. During nonconstant growth, dividend yield and capital gains yield are not constant. If current growth is greater than g, current capital gains yield is greater than g. After t = 3, g = constant = 6%, so the t t = 4 capital gains gains yield = 6%. Because k s = 13%, the t = 4 dividend yield = 13% - 6% = 7%.

10 - 23 Copyright © 2002 Harcourt, Inc.All rights reserved. The current stock price is \$54.11. The PV of dividends beyond year 3 is \$46.11 (P 3 discounted back to t = 0). The percentage of stock price due to long-term dividends is: Is the stock price based on short-term growth? ^ = 85.2%. \$46.11 \$54.11

10 - 24 Copyright © 2002 Harcourt, Inc.All rights reserved. If most of a stocks value is due to long- term cash flows, why do so many managers focus on quarterly earnings? Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings.

10 - 25 Copyright © 2002 Harcourt, Inc.All rights reserved. Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P 0 ? 0 1.7699 1.5663 1.3861 20.9895 1234 k s =13% 25.7118 g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12. P 3 007 30.2857 ^...

10 - 26 Copyright © 2002 Harcourt, Inc.All rights reserved. What is dividend yield and capital gains yield at t = 0 and at t = 3? t = 0: D1D1 P0P0 CGY = 13.0% - 7.8% = 5.2%. 2.00 \$25.72 7.8%. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%.

10 - 27 Copyright © 2002 Harcourt, Inc.All rights reserved. If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0: ^ = = = \$9.89. \$2.00(0.94) 0.13 - (-0.06) \$1.88 0.19

10 - 28 Copyright © 2002 Harcourt, Inc.All rights reserved. What are the annual dividend and capital gains yield? Capital gains yield = g = -6.0%. Dividend yield= 13.0% - (-6.0%) = 19.0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield.

10 - 29 Copyright © 2002 Harcourt, Inc.All rights reserved. Analysts often use the following multiples to value stocks: P/E P/CF or P/EBITDA P/Sales P/Customer Example: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. Using the Multiples of Comparable Firms to Estimate Stock Price

10 - 30 Copyright © 2002 Harcourt, Inc.All rights reserved. What is market equilibrium? ^ In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. (More…)

10 - 31 Copyright © 2002 Harcourt, Inc.All rights reserved. In equilibrium, expected returns must equal required returns: k s = D 1 /P 0 + g = k s = k RF + (k M - k RF )b. ^

10 - 32 Copyright © 2002 Harcourt, Inc.All rights reserved. How is equilibrium established? If k s = + g > k s, then P 0 is too low. If the price is lower than the fundamental value, then the stock is a bargain. Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until D 1 /P 0 + g = k s = k s. ^ ^ D1P0D1P0 ^

10 - 33 Copyright © 2002 Harcourt, Inc.All rights reserved. Why do stock prices change? k i = k RF + (k M - k RF )b i could change. Inflation expectations Risk aversion Company risk g could change. ^

10 - 34 Copyright © 2002 Harcourt, Inc.All rights reserved. Whats the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are fairly priced. One cannot beat the market except through good luck or inside information. (More…)

10 - 35 Copyright © 2002 Harcourt, Inc.All rights reserved. 1.Weak-form EMH: Cant profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but technical analysis is still used.

10 - 36 Copyright © 2002 Harcourt, Inc.All rights reserved. 2.Semistrong-form EMH: All publicly available information is reflected in stock prices, so it doesnt pay to pore over annual reports looking for undervalued stocks. Largely true.

10 - 37 Copyright © 2002 Harcourt, Inc.All rights reserved. 3.Strong-form EMH: All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but thats illegal.

10 - 38 Copyright © 2002 Harcourt, Inc.All rights reserved. Markets are generally efficient because: 1.100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. 2.These analysts have similar access to data and megabucks to invest. 3.Thus, news is reflected in P 0 almost instantaneously.

10 - 39 Copyright © 2002 Harcourt, Inc.All rights reserved. Preferred Stock Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.